TRANSFORM YOUR STOCKS INTO A MONEY MACHINE

 If you are holding stocks, you are possible holding a money machine with you.

Why do an investor buy stocks?

There are primarily two reasons to buy stocks.

1. Capital appreciation which occurs when stock price rises in value
2. Dividend payment which happens when company distributes its profits to share holders.

But neither of it is guaranteed.

Infact many investors get trapped when the stock they bought fell below their purchase price.

Hi this is Parshuram Desai,

and in this article I am going to show you how the capital invested in stocks can be efficiently utilized to harvest higher returns than stock ownership.

The goal here is to reduce the cost bases so that,

• An investor who is trapped at higher price can lower his acquisition cost.
• An investor whose stock is trading flat can start making profit.
• An investor whose stock is appreciating can harvest even higher returns.

and ultimately reduce the cost bases to zero.

The strategy which I am going to discuss here is a very popular strategy, however with a wider perspective.

Before diving into the strategy let us first discuss the few prerequisites of this strategy. 

•  Time horizon -  An investor should be willing to comfortable hold the stock for a mid to long term time horizon i.e. for 5 to 10 years.

• Quality of stock - For investors who have not bought the stocks but all willing to buy, for them the stock selection is very vital, as the performance of strategy will primarily depend on the quality of stock. A stock with strong fundamentals and growth potential is highly recommended.

•  Market capitalization - A large cap stock with proven track record and strong fundamentals have lesser chances of bankruptcy like domestic systemically important banks (D-SIBs) or top ten heavy weight stocks of Nifty50.

• Volatility or IV - Volatility plays a key role in setting up this strategy and also time required to reduce the cost bases to zero. A high IV stock has higher potential to generate better returns. However managing the volatility is very crucial. Personally I prefer high volatile stocks but for a beginner or novice investor high volatility could be a breaking point. hence choice of volatility depends on the experience and notional loss bearing capacity of an investor.

• FNO activated -  Since this strategy will be involving options, the stock which an investor is willing to buy should be FNO activated.

• Options liquidity - Stock should have good liquidity in its FNO segment. That means the gap between bid & ask price is very less and options are traded at fair value. Most of the Nifty50 stocks are highly liquid in FNO segment

It is highly recommended that the stock selected should meet all the above listed prerequisite. 

Now let's talk about strategy.

This is a very popular strategy, its called Covered Call.

Here I will be discussing how this strategy can be effectively implemented to reduce the cost bases to zero and recover the entire investment amount.

So, let's begin.

What is a Covered Call?

In simple works, covered call involves buying one lot of shares and selling one lot OTM call option.

Let's take an real life example.

On 18th November 2021,
Tatasteel is trading at 1186.
10% higher strike price call option i.e.
1300CE is trading at 25

I have picked 10% higher strike price because I am bullish in this stock for this month and I don't want to miss out on the benefits which I will be getting due to stock appreciation. 

However investor is free to select strike price depending oh his view. Since Tatasteel is in downtrend one may sell lower strike price call option to collect higher premium.

Strategy setup

Buy 1 lot Tatasteel at 1186

Sell 1 lot Dec 1300CE at 25

Have a look at Payoff diagram

 

As you can see from the payoff diagram, the upside is limited. However there is some cushioning on downside as well.

As long as Tatasteel stays below 1300 an investor gets to keep the entire premium of Rs. 25 on expiry.

Cost basis

Buy price Rs. 1186

Premium collected Rs. 25

Acquisition cost 1186 - 25 = Rs. 1161

By collecting a premium of Rs. 25 the cost bases has reduced from Rs. 1186 to Rs. 1161.

An investor should continue selling call option every month to get the premium. At the end of the one year, the cost basis will be like this:

Buy price Rs. 1186

Premium collected is 12 x 25 = Rs. 300

Acquisition cost 1186 - 300 = Rs. 886

That is about 25% reduction in acquisition cost. (300 / 1186 = 25% )

The investors who were trapped at higher price will get big relief at this point.

In long term say 4 years the cost basis will be:

Buy price Rs. 1186
Premium collected is 12 x 4 x 25 = Rs. 1200
Acquisition cost 1186 - 1200 = (-) 14

That means an investor has recovered his entire investment amount just by selling call options in four years. 

 However, in practical option trading is never so smooth.

There will be time when stock rallies more than 10% in a month or falls below 10%.

Suppose stock rallies 12% in a month, which in fact is a rate case and may not happen every month. Let us do some mathematics,

1186 x 12% = 1328

From  1186 stock rallies to 1328 on expiry i.e. Rs. 142

1300CE will be trading at 1328-1300 = Rs. 28. i.e. 25 - 28 = (-)3 loss, that is hardly any loss compared to the gain of Rs. 142 in stock. 

An investor will be very happy if this happens. He may buy back the call option at 28 and sell next month call option at 25 another 10% higher.

Now suppose stock falls 10% in a month.

Firstly, fall in stock price should not worry a long term investor holding a good quality stock with strong fundamentals.

However the premium collected by selling the call option will reduce the downside risk. An investor should continue selling covered calls. in long term the premium collected will completely wipeout the downside risk. 

Example

An investor is selling covered call for last six months and has collected Rs. 25 premium each month. Now in seventh month stock falls 10%, that is from 1186 stock falls to 1067

The loss in stock is 1186 - 1167 = Rs. 119

Total premium collected in covered call = 7 x 25 = 175

Here as you can see the premium collected in seventh months is more than the fall in stock price. The investor is actually in profit.

I would highlight here that in no case should an investor sell a call option below the buy price of stock, as he will be risking the premium collected if stock reverses and rallies back to original price.

Capital requirement

The investment for owning shares will depend on the lot size and share price. In case of Tatasteel lot size is 425 and share price is Rs. 1186 that amounts to 425 x 1186 = Rs 5,04,050.00

Margin required to sell one lot of 1300 CE is approx. Rs. 1.25L. However the stock which an investors has bought can be pledged to get 50% of margin and remaining 50% can come as cash. Hence net cash required for selling call is approx 65,000.

Total investment required for Tatasteel covered call is approximately 6L

Here is a list of top 10 Nifty50 heavy weight stocks with their capital requirement for covered call.

Key Takeaways

• Use covered call to reduce the cost bases.

• Upside gain is limited, however gains in stock will be considerably higher.

• In long term downside risk can be completely eliminated.

• An investor should avoid selling call below the purchase price of stock.

• Capital required is high and small investors may not be able to execute the strategy.

• Stocks can be pledged to receive margin money required for selling call option.

• Dividends received can be utilized to further reduce the cost bases.

• The premium received is in addition to the upside gains of the stock.

Please put your doubts and thoughts in comments below.

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Happy Investing.

Disclaimer:- The article is for educational purpose only. Please consult your financial advisor before making any investment decision.